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Credit analysis seeks to provide a fundamental view of a company’s financial ability to repay its obligations. While factors such as operating margins, fixed expenses, overhead burdens, and cash flows might be the same in equity and credit analyses, the emphasis is different for each. And while a strong credit rating does not seek to forecast strong equity performance per se, an understanding of credit ratings can help assess the equity performance potential of a company.

Key elements of a credit analysis

Financial Circumstances

The financial assessment of a borrower looks at its revenue and cost structures, both in isolation (using a cross section of meaningful ratios and metrics) and in relation to peer-group and industry benchmarks.

A company can be considered strong for credit purposes when it has a cost structure that allows it to produce generally higher-than-average profits during all phases of its business cycle. Such companies should show near-optimal capacity utilization at peak times and will also tend to produce above-average results even under the financial stress of a business downturn. In addition, a strong company should show that it has pricing power; that is, the ability to pass along any increases in its raw material and component costs to its customers in the form of higher prices. It should also show that it has management flexibility to adjust its production and labor costs in response to changing market conditions.

A company can be considered weak for credit purposes when it can only generate better-than-average performance during the peak of its business cycle when it has strong demand. A company is also considered weak when it can be regularly hobbled by burdensome fixed costs and has a limited track record of successful cost reduction, especially if its costs are already higher than its peers.

Competitive position

A company’s competitive position in its market can have a significant bearing on its ability to sustain its financial position, so detailed credit analysis may consider competitive factors and positions.

Indicators of a strong competitive position include a business strategy that appears consistent with industry trends and is adaptable to changes in the market. A strongly competitive company also demonstrates track records of product development, service quality, and customer satisfaction and retention. Strong companies may also benefit from high barriers to competition with strong patent and copyright protection, protective regulations, and franchise, permit, or licensing agreements.

Indicators of a weak company include a poorly articulated business strategy or one that is clearly at odds with market trends, products that show little or no price premium over competitive products, high rates of customer defection or dissatisfaction, and a low rate of reinvestment relative to peers.

Business Environment

Some factors may have only an indirect impact on a company’s financial positions, but they may still provide significant dimensions of a credit analysis. Country risk is an assessment of how the company’s business activities may be adversely affected by variations in the political, legal, regulatory, social, and tax climates in the countries where it does significant amounts of business. Currency risk in the broad sense considers not just the immediate balance sheet impact of adverse foreign exchange movements but also how changes in currency value might help or hinder the ability of the company to sell products or obtain components and raw materials. Industry risk considers how the industry’s business dynamics, legal and regulatory climate, and market factors could impact the performance of the individual company.

Indications of company strength include isolation from these risk factors. Some examples: Significant supply chain currency exposures may be well hedged; the company may have strategic alternatives to circumvent potentially problematic areas; the company’s earnings could vary relatively little as its industry moves though a technology cycle.

Indications of weakness, on the other hand, could include costs that vary significantly due to frequent currency translation gains and losses and earnings that change substantially as the company moves through the peaks and valleys of an industry cycle. Other indications might be susceptibility to business disruption from social unrest or variations in the political, legal, or regulatory climate.

Using the insights of credit analysis in equity investing

The fundamental factors evaluated in credit analysis tend to be the same factors considered in equity analysis: financial efficiency ratios (returns on equity, sales, assets, etc.), capital utilization, cash flow, gross margin, cost, and revenues. So are environmental factors such as regulatory climate, competition, taxation, and globalization. A typical credit rating is built from a weighted combination of these factors and provides a single score intended to reflect a borrower’s ability to repay its debts relative to other borrowers in its universe. For example, an AAA rating for a state government may not signify the same overall investment risk profile as an AAA rating for a corporation, but in each universe, the AAA-rated borrower can be considered to pose much less investment risk than a B-rated or C-rated borrower of the same universe.

Similarly, among business borrowers, a top bond rating does not consider all the factors that could help determine equity returns. Dividend payout rate, growth rate, and consistency, for example, could be important to shareholder value but not necessarily to creditors (except to the extent that dividends might be seen as competing for cash resources with debt service). But that said, there are indications that higher credit ratings may be associated with stronger equity returns.

Consider that among the 500 companies that make up the S&P 500, the median 5-year return of those companies with a primary S&P credit rating of A or stronger was 10.74% (for the period ended August 30, 2013), compared with a median of 6.53% over the same time frame for those with a primary credit rating of BB or weaker.1 To be sure, there were strong equity performers among those with weak credit ratings and weak performers among those with strong ratings. But results such as these may underscore that a consideration of credit factors could add value to equity investment selection.

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Related Lessons

While the concepts of risk and return may be common to both debt and equity, debt investment has its own language, principles, and metrics. Familiarity with these unique aspects is important for complete understanding of the market.

Article copyright 2013 by Wealth Management Systems Inc. Reprinted with permission from Wealth Management Systems Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.

Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.